Sunday, November 23, 2008

Repsol, Lukoil and Sacyr Vallhermosa Also Try Their Hand At Happy Families

“Happy families are all alike; every unhappy family is unhappy in its own way”Tolstoy

Well this is an interesting little fable of modern family life, even if all the families involved may not be ones which many of my readers would normally wish to belong to.

As is now reasonably well know Russian private oil company Lukoil is currently making a bid for the shares in Spanish energy company Repsol which are owned by the deeply indebted Spanish property company Sacyr Vallhermosa.

Shares in what is Spain's fifth biggest builder, and which currently occupies the somewhat ignominious position of being Spain's worst-performing stock this year, jumped the most in two years last Thursday (20 November) on reports they were about to sell their 20 percent stake in Repsol YPF to the Russian oil company OAO Lukoil. Sacyr, which said last week it was in talks over the possible sale of the stake, rose as much as 14 percent after EFE newswire identified Lukoil as a possible bidder. Lukoil is also reportedly willing to buy a further 9% of Respol stock owned by Criteria Caixacorp, the investment company established by Catalan savings bank La Caixa.

In fact Sacyr spent 6.5 billion euros building up their the Repsol holding, between October and December 2006, paying an average of 26.71 euros a share for the stake. It is estimated that the proposed sale of the shares may fetch 20 percent to 30 percent more than their current market value of 4.9 billion euros. To give an idea of what this means, we might bear in mind that Repsol shares closed in Madrid on Thursday at 13.61 euros, and rose 2.3% on Friday, while the Spanish newspaper El Economista reported that Lukoil was offering Criteria and the other shareholders 28 euros a share for the combined stake which constitues just under 30 percent of Repsol. An offer at this price would value the combined stake at about 10.2 billion euros, and would mean that Sacyr would walk away covering their initial investment almost completely, which in these hard times must seem almost incredible. I mean, you might like to ask yourself just why it is that Lukoil is able and willing to pay so much. Certainly Russian investors were asking just this very question since Lukoil shares dropped on the news - falling 4.6 percent to 778.74 rubles on the Micex stock exchange in Moscow on Friday (for my explanation of the apparent analogy more on this topic below).

But before going further there is perhaps one other little detail which is worth including at this point, and that is that since the combined stake of Sacyr and Criteria falls just short of the 30% mark which would give Lukoil effective control of the energy company (and make it obligatory to make a takeover offer to the other shareholders I think) it should not surprise us to find that the midewives of the deal are busy trying to identify those extra few shares which would push Lukoil over the 30% stake mark, and various names are being bandied around - like Mutua Madrileña (who have a two percent stake) or even La Caixa itself, since they effectively control another 6.1% of Repsol through their subsidiary company Repinves.

It's The Income Balance That Matters, Silly!

Now before we go into all the gory little details as to why exactly it is that Sacyr Vallehermosa find themselves so pressed to sell, perhaps a little of the background macroeconomics would not go amiss here.

Basically, as I explain in more detail in this post, the principal problem facing Spain's economy at the present time is financing the large external deficit, which has been running at around 8-9,000 million euros a month (8 to 9 billion in anglo saxon language, or around 10% of GDP) for most of this year. This deficit was previously financed by an inflow of mortgage funding when external investors were willing to supply this, but since these investors became increasingly nervous following the US sub prime turmoil in August 2007, Spanish banks have had problems funding the deficit (and funding mortgages) as we have been seeing via the dramatic slowdown in the Spanish economy that this reluctance to lend has produced.

Now.......

The principal way to resolve this external deficit is to have a major macroeconomic correction such that exports start once more to be larger than imports, but this process is a huge and painful one, and it is not surprising that the patient, lead by the country's government, and the prime minister, is extremely reluctant to enter the operating theatre. So we struggle on, month by month, but the monthly deficit still has to be paid. And this is where the sale of Repsol to Lukoil comes in. The issue is not that Lukoil being a non-Spanish company is a disadvantage (which is why the sort of criticism of the proposed deal which is coming from the PP is also completely out of touch with reality), but rather that it is absolutely essential to find an external buyer to raise more liquidity for the Spanish banking system, and if no other bidder is in a position to pay Sacyr what they need to make the sale viable for them, then Lukoil it is, "por las buenas o por las malas", as they say in Spanish. When you are up against the wall, and the only question is "do I shoot you today or tomorrow", the answers you give are not always coherent and well-thought-out ones.

However, just how dangerous trying to handle the Spanish problem in this way actually is, can be seen from the fact that one of the country's flagship companies is effectively being sold off for less than two monthly installments on the current account deficit (the August deficit was 6 billion euros). The problem really is that Sacyr has to sell (see more details below) but there is no ship left among what used to be called the "new Spanish armada" who still has the creditworthiness needed to be able to buy. Gas Natural (who were one of the last stalwarts) had their Long-term Issuer Default rating of 'A' and Short-term IDR of 'F1' placed on Rating Watch Negative by Fitch last July after they announced they would need a new 19 billion euro syndicated loan to finance their acquisition of a sizeable chunk of energy company Fenosa from another debt laden Spanish construction giant ACS.

Essentially going about things in this way eventually becomes totally unsustainable. Let me explain a little more. It is important to understand that the external accounts of a country are divided into two parts - a current account and a financial account - rather like the finances of a houshold can be divided into long term and a short term components like the acquisition of a property and the monthly mortgage installments which finance it. Well basically the structure of national financing isn't that different. Spain Incorporated can raise funds on the capital account by selling the shares of Repsol to an external purchaser, but we should never forget that these shares will then pay dividends, and these dividends will subsequently show up on the current account under the monthly income balance heading.

Now normally, in a developed economy, the income balance should hover around the neutral zone, as external investments attract income, while FDI etc from abroad carry associated outflows. Indeed I would say that the normal difference between a developed and a developing economy is in the underlying dynamics of the income section of the current account.

Well......

It is precisely when we come to examine this aspect of the Spanish case that we see the extent of the hole that has just been blown in the flagship's main bulkhead, since the income balance (which was never perfect) has been turning steadily negative (which was only to be expected with all those loans coming in) since the early years of this century, and now runs at a monthly outflow of 3 billion euros, or thereabouts. That is to say, the first 3 billion of any goods and services surplus which Spain eventually does manage to generate will be earmarked to pay interest and dividends on loans and shares previously sold to finance the property and merger boom. So roll your sleeves up lads and lasses, since there is a lot of sweating to be done to work off all this accumulated excess fat. Or maybe you would prefer to try liposuction?

And of course, the more we go down the road of selling off the country's underlying assets (and, of course there is plenty more to come here, see below on Acciona, Endesa and Enel, or think of the recent agreement to sell Iberia to British Airways due to Caja Madrid's urgent need for liquidity - Caja Madrid is Iberia's largest single shareholder) to pay for petrol for all the SUVs we have been buying with the loans we sold, the worse the long term position becomes.

Sacyr In Danger Of Having To Make Firesales

Rumours have been growing in investor circles of late that Sacyr Vallehermoso could be in such a tight financialcorner that it may forced into fire sales as time passes, if it fails to find buyers for assets it has put on offer to try to cover the massive debts it has hanging over it. Sacyr's share price has lost 69 percent of its value since the beginning of the year - as compared to a 39-percent slump in Spain's main IBEX stock index.

Like many Spanish builders, Sacyr borrowed heavily during the final years of the boom in an attempt to diversify out of residential property as the nine-year-long domestic housing boom clearly started to wind down. But as in so many other cases, those who buy near the end of a wave buy dear, and risk, if things don't go right, having to sell cheap, very cheap, unless of course a gleaming white knight in shining armour like Lukoil gallantly comes to your rescue (or is it so gallant, see below). Sacyr had net debt of 18.3 billion euros at end-June, or eight times market value. The ratio of net debt to net equity was 5.3, outweighing peers like Ferrovial at 3.9 and ACS at 1.2.

Sacyr thus announced on September 12 that it was putting assets up for sale, including its toll road unit Itinere and the 20 percent stake it has in Repsol YPF, all part of a major effort to pay down some of the debts. However, outside Lukoil no firm expressions of interest have materialized, and analysts are suggesting that this is because the prices being asked are far too high, as evidently it is hard to get good prices for assets in a bear market accompanied by a credit crunch. But this raises of course, the not simply incidental issue of why exactly it is that Lukoil is willing to pay so much over the going market rate, but we will get to that part later.

Sacyr did have around 347 million euros of debt maturing in the second half of 2008, but they have so far managed to refinance this, although there are somewhere in the region of another 2 billion euros worth set to expire in 2009, and worries about the difficulties which are likely to be associated with this process during the deep recession which Spain is now entering are putting a lot of pressure on the company.

Sacyr has been attempting to cover next year's debt haemorrage using a mixture of renegotiation, housing sales, dividend payments and the possible sale strategic assets, like its road toll unit Itinere. Citi infrastructure fund had been reported to be showing some interest in a possible purchase of Itinere, but there has been no concrete evidence of progress.

Press reports and analysts say the asking price for Itinere is in the region of 3.9 billion euros plus debt, and this sum is 400 million euros greater than the value of Itinere's failed initial public offering last April. Analysts tend to be rather dismissive of this kind of approach in the present climate.

"They were unable to do an IPO at 3.5 billion euros and four months later theywant to sell it for 3.9 billion? It's a joke," said an analyst at a major bankwho asked not to be named.

Apart from the asking price there are also clauses in existing Itinere loans that require a renegotiation of terms if it changes ownership, which also are reported to present a stumbling block to any Citi-type deal.

But the main problem which Sacyr faces right now is the current performance of Repsol itself, since the 5.1 billion euro bank loan which partially funded their purchase of the Repsol stake was guaranteed with Repsol shares, and on a margin trade basis. So when Repsol's share price falls, Sacyr must stump up more guarantees, putting further strains on the group's liquidity. And, of course, Repsol shares have been having a very hard time of it recently, evening fell by as much as 20 percent in a single day on October 22 over concerns about the energy company's exposure to Argentina, which is itself getting into ever deeper water with the international investment community: a further Argentine default would be the last thing that Repsol (and naturally Sacyr) need right now. Subsequently Repsol stock has regained some of the lost ground (and is now trading at around 15 euros) but this is still a far cry from the 26.7 euros a share Sacyr paid in 2006.

Sacyr has so far pledged 40 percent of its rental property business Testa as additional collateral for debt taken out to buy the Repsol stake, and Goldman Sachs in a recent note suggest that as long as Repsol's share price remains above 12.9 euros per share, Testa will cover the collateral under current terms, but in Sacyr's present state that is a very wobbly if. And if Testa shares become no longer sufficient, then Sacyr will have to reconvene with banks to discuss alternative collateral, and this they need like a hole in the head, hence all the haste and attention being lauded on the Lukoil suitor.

Analysts are agreed the longer it takes to sell assets to shore up its balance sheet, the more worrying Sacyr's borrowing levels will become and the greater the risk of fire sales.

Spain's leading water company Aigues de Barcelona (Agbar) has also expressed an interest in the water division of Valoriza part of Sacyr's environemntal division. Valoriza is valued at around 1 billion euros. Agbar and Sacyr do not seem to be in actual talks at the present time, since the sum involved is insufficient to materially change the main problem, and Sacyr is more focused on Itinere and its Repsol stake. The Spanish newspaper Expansion reported that the sale process of Valoriza is being handled by Italy's Mediobanca and that as well as Agbar interest has been shown by Veolia which is a former partner of another Spanish builder - FCC - and operates in the environmental services business in Spain.

Any eventual sale of these units would not be the first such move by Sacyr to keep moving ahead by selling assets, since back in April Sacyr sold its stake in French builder Eiffage, following a bungled takeover bid, and in the process cutting its borrowing by 6 percent.

Sacyr representatives also recently met with lenders on its Repsol loan - who are lead by Banco Santander - to discuss the collateral clauses in their agreement. In principle under the original terms of the loan up until December 21 Sacyr have to put up collateral equal to at least 105 percent of the total loan, after that date this figue increases to 115 percent. In addition the interest rate on the loan rises to 1.10 percentage points more than euribor benchmark rates from the present 1 percentage point after the same date, and this is another reason why Sacyr would like to see their Repsol stake turned into history before xmas.

The company has already pledged the maximum amount, 1.275 billion euros, of shares from its property unit Testa Inmuebles en Renta SA allowed under the terms of the loan. Sacyr began using Testa stock in January after Repsol, whose shares were initially assigned as collateral, declined below the 20 euro a share watermark, according to a regulatory filing Sacyr made on January 23 2008. Repsol fell to 12.92 euros on Oct. 28, the lowest in more than five years, and are down 40 percent over the past year. Sacyr has fallen 71 percent this year, the largest fall of any of the 35 most-traded stocks included in Spain's IBEX Index.

So What About Lukoil, Why Should They Be So Interested In Repsol?

On the face of it the justification for Lukoil's interest in Repsol is not as self-evident as it at first appears, but then little in modern Russia ever is.

Lukoil has itself been struggling from a liquidity crunch back home in recent months, as the price of oil has dropped and lack of investment by the Russian oil majors means that field depletion is leading to ever lower levels of domestic output. Indeed the price of Urals crude, which is Russia's principal export blend, was down 68 percent from the July peak last week, hitting the "bargain basement" level of $44.80 a barrel.

Lukoil, which already owns refineries in Bulgaria and Romania, agreed in June to pay 1.35 billion euros to buy into an Italian refinery with partner ERG SpA. Lukoil, which has $1.9 billion in debt and loans scheduled to mature this year (although obligations will drop to $609 million in 2009 and $525 million in 2010) had only $1.66 billion in available cash at the end of June. So what is going on here?

Well, as I have said, Russia is facing its own credit crunch and construction slump, and as a result Vladimir Putin did recently introduce his own $180 billion dollar bank-bailout and loan guarantee scheme. Could it be that Lukoil want, in some shape and form or another, to take advantage of this potential funding to acquire the Repsol stake? Well, there are reasons for imagining that there might be a very strong incentive we haven't yet touched on for them to do just this. The principal reason among such reasons (or the bitter and compelling inner logic of the issue) was basically put under the spotlight by the recent announcement (and large gaffe) made by central bank Chairman Sergey Ignatief when he said that Russia's currency (aka the ruble) had a "certain tendency toward weakening'' . Since the ruble normally trades in a tighly controlled trading band this widely interpreted as meaning that the ruble is about to be devalued, and while estimates of the extent of the devaluation vary, something in the 15% to 20% range would be a good guess, I think.

Viewed in this light, a loan of some 6 or 7 billion euros (denominated in rubles) under the Putin bank bailout and credit guarantee scheme wouldn't look to be too bad a proposition, especially if it was subsequently to be repaid in rubles following a substantial devaluation. (I mean I don't think I will get here into any rather Machiavellian type of speculation about how a hypothetical demand for 7 billion euros from the central bank foreign exchange reserves - which are of course under considerable pressure right now - would effectively constitute a very large "devaluation put", and offer us all the hallmarks of being a self-fulling declaration of intent). And don't start imagining that such an idea is very far fetched, since IMF Managing Director Michel Camdessus effectively had to resign at the end of the 1990s following continuing scandals about IMF support loans being diverted into currency speculation. And that such activity is not entirely dead in today's Russia was confirmed by last week's threat by First Deputy Prime Minister Igor Shuvalov that Russian banks who convert government aid into foreign currency rather than lending to troubled companies would risk losing access to state funding .

Obviously, in addition to any incidental gains they may make in the forex markets, Lukoil would also gain access to Repsol's extensive refining capacity - 1.23 million barrels a day according to their website - which includes five refineries in Spain, three in Argentina and one in Peru. Repsol also has holdings in another refinery in Argentina and two more in Brazil. And indeed the deal has a certain logic from the Repsol point of view, since the tie-in with Lukoil would give access to Russian supplies while the company currently relies on South America for about 95 percent of its present oil reserves. But then, as is normally the case, nothing in life ever comes free, and in this case the strings attached are important ones, very important ones.

Spain's Builders Up To Their Eyes In Debts

Obviously Sacyr is far from being alone in its current "tight fix". Acciona SA, is another Spanish builder struggling under the weight of a growing mountain of debt. Acciona came to international prominence when it bought joint control of power company Endesa SA last year together with Italy's Enel SpA. Well, the Madrid-based builder said July 30 that first-half net income fell 15 percent to 314 million euros as the takeover had increased debt costs, with Acciona net debt rising to 17 billion euros in Q2, up from 10 billion euros a year earlier. Acciona has recently stated it is in talks with creditors in an attempt to refinance the debt it contracted to make the purchase of the Endesa stake, but strongly denied that it has already committed to selling the stake in 2010. This denial followed a report on Spanish financial website El Confidencial that Acciona has assured its creditors that it will exercise an option it has to sell the 25 percent stake in Endesa to Italian partner Enel in 2010.

Despite the denial the decision to sell would be a logical one, and appears as if it may well form part of an agreement Acciona have reached with a group of banks lead by Banco Santander not to link Endesa's share price to the collateral required for the 7.1 billion euro in loans it received for the stake buy, as previously agreed. The 2 loans were due to have expired on 31 December 2012, but Acciona was obviously anxious to get the conditions changed.

"Acciona has not committed to exercising the March 27, 2010 put option but thatdoes not mean that the company will not exercise it on that date or at a laterdate," the Spanish builder said in a statement to the stock market regulator.

Under the previous contract Acciona needed to give additional guarantees in the case that Endesa stock fell below 25 euro per share and this had been the case since October 6. Such guarantees -or margin calls - disappeared under the new contract. In exchange the new contract increased interest rates on the entire sum of the debt - doubling the premium when compared with the previous rate of 60 basis points over Euribor. Thus we find ourselves in exactly the same position vis-a-vis margin calls as Sacyr has with Repsol. The 21 syndicated banks behind the principal Acciona loan include Santander, ING, La Caixa, RBS, Caja Madrid, Calyon and Natixis, and the loan effectively financed the original 25 percent stake that Acciona took in Endesa following a 42.5 billion euro bidding contest in alliance with Italy's Enel which currently owns some 70 percent of Endesa. At the time Enel and Acciona came out in front of competing bids from Germany's E.ON EONG.DE and Catalonia-based Gas Natural.

Back in July the Italian newspaper Corriere della Sera reported that Enel was in talks to buy out Acciona for 10 billion euros, adding the point that any such deal would needs the approval of Spanish prime minister Jose Luis Zapatero - so Zpt is going to be busy, since he has already flown to St Petersburg. Corriere also suggested that Endesa's development was currently being paralysed by an ongoing dispute between the two principal shareholders. The paper stated that there was an urgent need to find a solution to overcome the repeated obstacles raised over Endesa board decisions by Jose Manuel Entrecanales, who is chairman of both Acciona and Endesa. Enel has plans to expand Endesa outside of Spain, while Acciona is simply looking to sell its stake to pay down some of its 18 billion euros of debt, according to the paper.

Valuation of Acciona's stake in Endesa depends on valuation of Endesa's wind power generating plants, which Acciona would like to acquire. Any finally agreed exit price for Acciona would also need to take account of the put option it holds to sell the Endesa stake by October 2010 to Enel at a price of 10 billion to 12 billion euros.

Meantime another Spanish building dynosaur - Ferrovial - labours on with its heroic attempt to try to sell its Stanstead airport holding in the UK - but at least in this case the asset being disposed of does not form part of Spanish national patrimony. The Spanish builder that spent $20 billion buying the British Airports Authority is taking longer than anticipated to sell London's Gatwick airport because of the global financial crisis, according to its Chief Financial Officer Nicolas Villen.

``It's difficult to say where we are in this crisis,'' Villen said in aninterview in New York late on Nov. 14. ``In this financial crisis it will alwaysbe more difficult for potential bidders of this asset to obtain financing. So Ithink it's going to be a lengthier process than usual.''

BAA currently provides poor service and has failed to plan for extra capacity, according to a recent report from the U.K. Competition Commission, adding a recommendation that the company be stripped of the capital's Gatwick and Stansted airports and either Glasgow or Edinburgh in Scotland. Both Heathrow and Gatwick had a drop in traffic of about 0.5 percent in the first nine months of the year, described by Villen as a "moderate decline" when compared with earlier economic crises, when traffic fell by 3 percent or more.

Ferrovial had a third- quarter loss of 17 million euros, which compared with a year earlier profit of 49.6 million euros. The company's total debt fell 5.4 percent from a year earlier to 28.6 billion euros in September.

Fomento de Construcciones y Contratas (or FCC) - Spain's third largest builder - on the other hand had net debt of 8.51 billion euros at the end of the first quarter, 54 percent more than a year earlier, and up from 7.97 billion at the end of 2007.

And It's The Same Picture Among Property Developers

Spanish property group Tremon last week became the first major property developer to follow in the footsteps of Martinsa Fadesa, and file for administration after failing to meet debt payments, causing a fall in the shares of those banks which have total exposure of around 1 billion euros to the company. Tremon is thus the second large Spanish property group to seekadministration this year following the July decision of Martinsa Fadesa. Among Tremon's biggest creditors are Banco Popular, which has an exposure of around 200 million euros exposure, unlisted savings bank Bancaja with 100 million and Banco Pastor which has 95 million.

"Our debt is up to 1 billion euros, and more than 90 percent is held by apool of 16 banks. Administration was filed last thing on Friday," saidlawyer Angel Romero, who is acting as Tremon's spokesman.

Spanish property firm Metrovacesa recently stated they expect to meet the terms of a 3.2 billion euro syndicated loan by the end of the year. At the end of September, Metrovacesa's core earnings were 2.13 times its financial costs, below the minimum limit of 2.25 times the company is obliged by creditors to meet by the end of 2008. Among other conditions attached to Metrovacesa's 3.2 billion euro loan is that the company maintain its 6.9 billion euros of debt at no more than 55 percent of asset value. The company said its debt stood at 54.4 percent of assets on Sept. 30 when it published its third-quarter results. If Metrovacesa does not comply with the conditions of the syndicated loan, the banking syndicate can order its immediate repayment and order the company to talk to its creditors.

Spanish stock market regulator CNMV last week requested Metrovacesa to provide it with details on where it stands with repaying the syndicated loan, as well as with refinancing 810 million pounds worth of borrowing with HSBC, the money was used to buy the bank's London offices. Metrovacesa stated in reply that the company was still in talks with several financial entities over refinancing the HSBC debt, which falls due at the end of November, but had yet to reach a deal.

Real estate company Reyal Urbis also recently reached a deal with creditors to refinance debt of 3.006 billion euros. In a statement to the Madrid stock exchange regulator, Real Urbis stated it had obtained two new credit lines which gave it "the necessary liquidity for its operative management". The new deal refinances two syndicated loans signed in 2005 and 2006 in addition to other loans and debt issues. Under the new financing terms, the company has been able to postpone the next payment on its debt until October 2011 and signed up to twice-yearly payments after that date until 2015. Thus it seems there is a tendency to postpone into the future - to 2011 at least - and then perhaps at that point a critical moment will be reached in all this, assuming that is that it doesn't come before, which if we look at the very dramatic state of the contraction in the Spanish economy is a possibility which certainly can't be excluded.

In 2015 - should we get that far - the company will then have to pay off the remaining 40 percent of the debt. One of Spain's largest developers, formed through the merger of Urbis and Reyal in 2007, Reyal Urbis said it had net debt of 5.5 billion euros when it reported its first-half results.

Another Spanish real estate company, Colonial, recently reported a nine-month net loss of 2.475 billion euros after taking charges for plunging asset values. The loss compared to a profit of 356.9 million euros for the same period last year. Group sales for the nine months to end-September dived 23.7 percent to 472.8 million euros, but still the "walking dead" real estate firm managed to put through a debt restructuring in September. Funding banks had previously taken partial control of Colonial earlier this year when some of its shareholders failed to meet obligations. Residential land sales fell by over a half in the fisrt nine months of 2008 and Colonial's net debt stood at 8.975 billion euros as of the end of September.

And As Spain's Government Sells Bonds......

Spain's government still effectively seems to be in denial about where all of this more or less inevitably leads, and is still trying to keep alive the ailing builders and property developers on an emergency life support ("reanimator") system by selling government debt to guarantee the ever more risky private variant. Thus last Thursday (20 November) the (previously-postposed) first special "reverse auction" was held and the Spanish government bought 2.115 billion euros of bank assets out of a maximum possible of 5 billion euros. Spain's Economy Ministry said a total of 4.562 billion euros of assets had been offered. Spain's Fund for Acquiring Financial Assets (FAAF) held the reverse repo auction for investment grade, 2 year asset-backed-debt issued after Aug 1 2007. It plans to purchase up to a further 5 billion in 3-year mortgage-backed debt in December.

The government has said it plans to buy up to 50 billion euros in bank assets in 2008 and 2009 to provide a market for longer-term bank debt which institutions cannot sell to investors or the European Central Bank. The head of the State Credit Institute (ICO) Aurelio Martinez argued after the auction that some banks may have felt inhibited from participating due to fear of being stigmatised. FAAF received 70 bids worth 4.56 billion euros from 28 banks. Of those, 51 bids from 23 different banks were accepted, the rest were rejected after failing to meet criteria ranging from their size and interest rate to the participation of the bank in lending markets. Questions are being raised by analysts about the effectiveness of the fund given the limits on how much banks can sell, the stigma attached to sales, and the comparative ease of borrowing more anonymously from the European Central Bank.

The other side of this particular coin is however the little question of just how all this bank funding is going to be paid for. To some extent this became clearer this week since the day before the auctions the Spanish government previously paid its first visit to debt markets for funds in connection with the programme, and the first programme-specific auction was duly held on Wednesday 19th November. Remarkably the sale generated quite strong demand and even revealed comparatively stable spreads. Indeed demand was such that the Spanish treasury was able to issue 200,000 euros more in debt than initially anticipated in the special 4.4 billion euro sale to cover bank asset acquisitions.

That outcome is especially surprising as it compared with a disappointing demand in a sale of new 10-year German bunds held the same day, and which met fewer bids than the sum issued. Amazingly even the spreads remained stable. Investor appetite may be cautious in view of the high levels of uncertainty surrounding sovereign issues and debt levels over the next few years, and may be showing a preference over debt with a somewhat shorter maturity horizon. Anecdotal evidence (as encountered by the author of the present post) also suggests that many Spanish people may be seeing treasuries as a "safe haven" against a banking system where lack of reliable information makes them nervous about using deposit accounts.

Spain has said it plans to issue issue up to the full 50 billion euros earmarked for this kind of bank support in public debt (thus raising around 5% of GDP in new debt) over the next two years. Spain's deepening economic problems has caused the spread between 10-year Spanish bonds and the benchmark German bund to widen to 60 basis points in October from 8 bps a year earlier.

The much smaller yield differential on shorter term debt was reflected in a yield of 2.7 percent on the Spanish two-year debt sold on Wednesday which compared favourably with a rate of 2.71 percent in the secondary market the previous day. This paper traded in a band of 2.503/687 on Thursday in the secondary market and its spread against comparative German debt remained steady at 25 basis points.

Spain is to hold further auctions December and January to sell bonds and bills. Of course it is not clear who exactly is buying this paper. If it is the Spanish themselves then it will be of little avail (as per the above external financing argument), but Industry Minister Miguel Sebastian did tell Reuters on October 20 that Spain was appealing to Arab sovereign wealth funds to buy the bonds. With what success we have no idea.

........The Government Deficit Rises Sharply

As a result of all this selling Spain's budget numbers are deteriorating fast and could hit the EU 3 percent fiscal deficit limit as early as by the end of this year, according to a statement from central bank governor Miguel Angel Fernandez Ordoñez before the Spanish Senate last week. The limit itself is only a technicality at this point in time, but it is astonishing to learn that in the space of less than one year Spain will have gone from a budget surplus equal to 2 percent of GDP to a deficit of 3 percent. This is a shift of 5 percentage points in a year, and of course, if this continues into 2009 and 2010, then the debt to GDP levels will start to shoot up rapidly.

Fernandez Ordoñez may well not tell you (as I say here) the whole truth, but he normally does tell you the truth and nothing but the truth, andn he is thus fast becoming one of the main sources of reliable information in what is now a worm-infested Spanish communications system (just as another piece of anecdotal evidence here, I was to have travelled to the Basque Country tomorrow to appear on a regional TV programme about the merger between local cajas Kutxa and BBK, but the programme was cancelled - for the second time now - for the simple reason that the production team could find absolutely no one apart from me who was willing to talk in front of the cameras about this kind of topic. Thus hundred of Tertulias, thousands of empty words, and little in the way of cool clear light on the subject. The wheels of metaphysics turn round and round, but I see no motion in the drive shaft...). Anyway, Fernandez Ordoñez has been quick to pick up on the fact that the government's present forecast of 1 percent growth next year — unveiled just weeks ago in the 2009 budget — is already well out of date and the budget provisions need to be revised accordingly, and on the basis of much more realistic economic forecasts. If they don't start to do this, then the spreads will inevitably only start to rise further and faster as investors get more and more paniky about the actual underlying debt dynamics in the absence of any kind of realistic information.

"We must make a downward revision of prospects for economic growth in the nextfew quarters," Fernandez Ordoñez said.

I think everyone now accepts what Prime Minister Jose Luis Rodriguez Zapatero explicitly said last Thursday: namely that Spain will inevitably exceed the European Union budget deficit limit as it tries to spend its way out of recession. EU budget rules specifically allow for countries to breach the deficit limit of 3 percent during exceptional circumstances, and Zapatero rightly said such conditions existed in Spain, where the economic contraction is about to become much sharper than elsewhere in Europe.

"Whether it (the deficit) goes to 3.5 or 4 or 4.2, we will have to wait to seehow the economy develops," Zapatero said during a press conference. "The Spanish government is not going to resign itself to recession, we're going to try to grow and provide jobs,' he said. "We're going to use the public deficit to keep social promises"

Of course, Zapatero is right here, Spain does need to use its fiscal leverage - Spain's debt to GDP ratio was around 20 percentage points below the EU average at the start of 2008 - to address the probelms. But just one more time Bank of Spain Governor Miguel Angel Fernandez Ordonez is also right in urging Zapatero to show some sort of fiscal prudence and hold back some public funds in case (I would say for when) conditions get even worse. Ordonez is explicitly expressing his fears that a focus on short-term, emergency measures, without a total restructuring plan, may rule out deeper structural labour and service market overhaulswhich will be needed in the future to raise competitiveness and promote long-term growth.

I will be even more explict. As I have argued here, and in numerous other posts, the present Spanish depression is being caused by deep-seated structural problems, and not by transitory cyclical ones. Thus, using fiscal policy as if this was simply a classical problem of the business cycle is a big mistake, on my view, and is needlessly using up vital ammunition which will be badly needed to take us through the battlefields which lie ahead.

We are now facing an economic slump of unprecendented proportions in Spain, and more than likely an ongoing problem of outright price deflation. To fight this combination using the traditional fiscal and monetary policy tools simply will not work - they are likely trying to drain an ocean with a teaspoon. We need new tools, fresh thinking, and a complete change of course. And the sooner we get them the better.

Well, this has been a very lengthy post. If anyone else has actually arrived this far, I can simply thank you for your patience and your perseverence. You are undoubtedly the kind of enduring person the new Spain is going to badly need. I hope you have learnt as much in reading this as I have learnt in the doing the background research which was necessary for writing it.